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Return and Correlation in Currency Funds

Paul Justice, CFA

Paul Justice: I'm Paul Justice with Morningstar, Associate Director of ETF Research. I'm joined by currency guru and macroeconomist Axel Merk. Thank you for being here.

Axel Merk: My pleasure.

Justice: Many investors don't have much experience in currency investing. Some consider it an alternative asset class. And I'd like to inquire with you, of three funds that you have available, how can investors decide to use these funds, and exactly how they differ?

Merk: Sure. We consider currencies an asset class. We believe in the currency space, like in the equity space, you can be a long-term or a short-term investor. You can be a speculator.

And what we do is we are very transparent. We typically do not use leverage. We have three mutual funds. The Hard Currency Fund, seeking to profit from a declining dollar versus a basket of hard currencies. So, if you are long-term negative on the U.S. dollar, if you think that all of the spending we do in the U.S. might have a negative impact on the U.S. dollar, the Hard Currency Fund is something to consider.

Justice: I'm sorry. What would you define hard currency as?

Merk: Hard currencies, in our definition, are currencies backed by sound monetary policy. It's very much a macro approach. It's an approach where we gradually rebalance over an extended period of time. Central bank policy doesn't change overnight. If countries behave better, as far as their central bank policy is concerned, then that's something we consider for inclusion.

Justice: Sure.

Merk: Our second fund is our Asian Currency Fund. The Asian Currency Fund is very much a play on a revaluation in China. We have a substantial Chinese yuan exposure. We believe that the countries that are at what we call is the higher end of the value chain are better equipped to allow the currencies to strengthen. Whereas, the weaker countries, like Vietnam or the Philippines, might engage in potentially competitive devaluation, and, as a result, might not be interested in allowing the currency to appreciate.

Now, a third fund is the Absolute Return Currency Fund. That fund seeks to profit regardless of market conditions. So, again, it's a fund that typically does not use leverage. But there we go a long and short different currencies. It's a more quantitative approach. We rebalance on a monthly basis.

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And, if you think about it, in the currency space you have many non-profit-seekers. You have folks like governments, tourists, corporate hedging departments. They don't typically seek to make a profit when they engage in currency trading. And so there are potential profit opportunities. And, what you can do in the currency space, you can design a portfolio that has a very low correlation to anything else people may be holding.

So, for example, you can go long Australia, short New Zealand. The currency, and the returns they are generating, are going to be almost certainly having a very low correlation to anything else investors may be holding. And so to really have a component that has a low correlation to anything else the investor may be holding, the Absolute Return Currency Fund is something to look at for investors.

Justice: What are some of the fundamental factors that you are going to look at when deciding to overweight one currency relative to another?

Merk: In the Hard and Asian Currency Funds, it's very much a macro-driven approach. In the Absolute Return Currency Fund, it's a three-layered approach. Furthermost, it's a quantitative approach, that we have a risk and a macro overlay to that.

In the quantitative approach, what we do is, we optimize and improve on some very basic currency strategies. People may be familiar with a carry strategy, or a valuation-based approach that uses purchasing power, or even a momentum strategy. Because you have these non-profit-seekers in there, some of these strategies may be profitable. And we optimize those. We improve on those.

We also have a resource strategy that goes into it. Many currencies have a high correlation to commodity prices. And so, based on that, you can devise a strategy. The Absolute Return Currency Fund is very much quantitatively driven, and then optimized to reduce the risk profile.

Justice: And just in case people are worried about models going wild, you do have some oversight to override the qualitative factors, within there, to make sure that they make common sense to use.

Merk: Yes, we do have a macro overlay. And we are best known for our macro views. We do let that go into play. Having said that, one of the key differences to other currency players is that we do not use leverage.

And people always think of the currency space being so risky. In fact, if you do not use leverage, the currency space is less risky than either the equity or the fixed income space. People talk about it when the euro moves from 135 to 136, but that is not a big move on a percentage basis. It is significant because it moves economies, but not as far as the risk/return profile is concerned.

Justice: Now, I understand the diversification benefits as far as low correlation, but oftentimes, people will say in currency investing it's hard to get rich if you own cash. And, when you buy a foreign currency, you're potentially just investing in cash of another country. Could you talk about the return prospects then, as well as the correlation benefits?

Merk: Well, we are not trying to buy a hot Internet stock generating huge returns every month. We are really focusing on the low correlation. Obviously, low correlation is only as good if you are, in the end, generating a positive return. And we can't promise that, of course. But what we do is we take great effort in our modeling to come up with something where we are very confident with, that we can provide value to investors.

And, to put that into context, in our Hard Currency Fund for example, we tend to sell the dollar and buy other currencies. That risk/return profile is very well known. The fund is very established. The Absolute Return Currency Fund is younger. But because we go long and short, difference types of currencies in that fund, we believe that over the medium-term, the risk profile will be lower than that of the Hard Currency Fund. And, in the short life the Absolute Return Currency Fund has had, we believe we've shown that already.

Justice: Now, I appreciate the commentary that comes up on merkfunds.com. You give great insight to the markets. And I think that the logic behind the decision-making process would resonate with a lot of investors. I invite them to sign up for your newsletter, as I do. Thank you. I appreciate you being here.

Merk: My pleasure.